By Joris Delanoue, CEO of Fairmint

Tokenization is enabling stock trading at any hour, as well as international access to U.S. markets. More people are trading more equities around the clock, but a fundamental question still remains: who legally owns a share once it changes hands?

Tokenized equity is a digital asset that represents ownership in a company’s stock that’s issued and recorded on blockchain and managed by smart contracts, leaving spreadsheets behind.

They can enable greater liquidity and end the idea that the market has to close at 4 p.m. or on holidays. Now, traders can trade at 2 a.m. if they want.

But different systems tell a different story about who is the actual shareholder and who gets paid after a trade. Right now, a token’s ledger, a transfer agent’s records and a broker’s books can offer different answers, and current rules don’t say which one controls.

A new test to determine authoritative ownership may be necessary.

When that 2 a.m. trade happens, the smart contract executes, the blockchain technology records the trade and cash may move. But if the token ledger, the transfer agent’s master securityholder file and intermediary books do not update simultaneously, which system determines who is entitled to the payout? You have the same problem when a token is pledged, an intermediary fails or a transfer is disputed.

Execution, clearing, settlement and legally effective ownership are all separate items. All need to be addressed properly to ensure the market operates correctly and all parties maintain the ownership, entitlement and interests they should.

Execution is the successful filling of a buy or sell order in the market. Clearing happens when the buy and sell orders are matched to confirm price, quantity and date are identical, with the National Securities Clearing Corporation (NSCC) processing eligible transactions as a middleman. Settlement is the moment securities are delivered against cash to the buyer. For most U.S. investors, they don’t actually hold the share itself, they hold a securities entitlement under Article 8 of the Uniformal Commercial Code (UCC). Only investors who register directly through a transfer agent’s book-entry system are named as shareholders, though with tokenized securities it may depend on the legal structure of the token who is registered. Regardless, entries alone for each event don’t accomplish all of these and that’s where the problem comes in.

Back in 1968, Wall Street went through a similar issue, causing offices to be shut down on Wednesdays to deal with the overwhelming amount of paperwork. The volume of certificates and records to handle after massive amounts of trading left back offices underwater. The response was broader than depositories or book-entry transfers. Article 8 of the UCC was introduced in the mid-20th century, revised in 1977 to accommodate uncertificated securities and again in 1994 to create the security-entitlement model. Those new clearing, custody, recordkeeping and regulatory arrangements established how trades were processed, when settlement became final and how discrepancies were resolved.

But now that problem has circled back, and the Securities and Exchange Commission has released the new Innovation Exemption, allowing limited trading of tokenized U.S. stocks to a new venue under this five-year conditional rule. The rule requires tokenized stocks to provide holders with rights and privileges equivalent to those of traditional stocks, but it does not automatically establish a common framework for proving, transferring and enforcing those rights across different infrastructures.

On Sept. 1, the SEC proposed modernizing its transfer-agent rules to reflect electronic communications and blockchain technology. It doesn’t specify any particular technology to be used, but does say that existing recordkeeping, safeguarding and reporting requirements must be met.

But here lies the next problem:  these existing laws establish ownership and entitlement rules, but tokenization introduces new structures that require clear legal classification, responsibilities and interoperability between records. Essentially, changing the technology used doesn’t answer how to maintain those legal ownership records without creating the potential for error. Adding a token just changes the structure. The way it stands, an official legal record exists of who owns the company’s stock, but it doesn’t cross-check master lists with Wall Street clearinghouses or online brokers. New laws ended the 1968 paperwork crisis, and new legal classifications and regulatory standards may be necessary now that tokens have been introduced.

Those updates should answer the question of how to maintain authoritative ownership. Article 8 already does that for indirect holdings with each tier having its own records, but when it comes to tokenization, it doesn’t answer which tier tokens fall under, leaving the ownership question up to interpretation.

A New 3-Part Test

Any new rules for determining authoritative ownership of tokenized stocks should be able to answer three questions, similar to questions the market had to resolve during the paperwork crisis.  

First, what specific event legally completes the transfer? Not just executed or technically settled, but puts it formally into effect, registering on the issuer’s books.

Second, which record rules if there is a discrepancy between the token ledger, master security file, depository record and/or intermediary books?

Third, who has the legal right and duty to fix errors and assign losses? 

This test isn’t new, but must be applied again now that tokens, with unclear tiers under Article 8, are here. That’s why the rules being considered right now must answer those questions preemptively, not reactively once errors occur. The structure that comes into play across the market must satisfy all three parts of the test; otherwise, tokenized assets merely transfer without establishing legal ownership.

Clear regulations set universal rules. Different institutions can use varying technologies because the issue isn’t the blockchain itself, but how different models interact and preserve investor rights. But universal rules of how records are kept and when event changes occur, regardless of the technology used, are key to moving forward. Clear designations of when a token transfer will update the master securityholder, how double counting is prevented, how corporate actions reach the true owner and who corrects an error. The architecture must also specify how collateral interests, their priority and any permitted reuse are recorded so that the same position is not counted twice and competing claims can be resolved. Systems then compete on cost, access and performance without different definitions of ownership.

The future success of tokenized stocks doesn’t depend on how much can be traded at any hour of the day. It’s determined by whether trading can move faster without ever causing the market to shut down, and that holders always have access to the rights and responsibilities that make a share a share.

Author disclosures:

Joris Delanoue is co-founder and CEO of Fairmint, an SEC-registered transfer agent that operates fully onchain.

Jørgen Ouaknine holds a PhD in law and works in financial market infrastructure and distributed ledger technology. He contributed to this article in his personal capacity; the views expressed are his own and do not necessarily represent those of any organization with which he is affiliated.